“When you buy anything with lots of leverage, it does not require a whole lot to go wrong to lose it all.” – Barry Ritholtz
Given the easy availability and affordability of debt, the majority of corporations do resort to debt financing rather than opting for equity. But at times, debt burden can become detrimental to the company’s existence.
The crux of debt financing is that as long as corporations can generate a higher rate of return compared to the interest rate they have to pay, there’s nothing to worry. However, the problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant or exceeds the rate of return.
Since companies with large debt loads are more vulnerable during economic crisis and can even go bankrupt in the worst case scenario, understanding the amount of financial leverage a company bears is crucial.
Over time, varied benchmarks based on leverage ratio have emerged as an efficient tool to evaluate a company’s credit worthiness for potential equity investments. The most popular among them is the debt-to-equity ratio.
Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio implies that it has a more or less financially stable business, thereby making it a more worthy investment opportunity.
With the second-quarter earnings season in full swing now, investors must be eyeing companies that exhibit a solid growth trajectory. However, blindly pursuing high earnings yielding stocks might be a drain on your resources if these have a high debt-to-equity ratio.
This is because a high debt-to-equity ratio indicates a huge level of repayment that the company has to make in connection with the large debt amount, which had once boosted its earnings growth. This makes the company’s so-called solid earnings very volatile.
Therefore to avoid losses, it is wise to go for stocks bearing low debt-to-equity ratio.
The Winning Strategy
Obviously given the fact that uncertainty can hit the global market anytime, choosing low leverage stocks will be a safe strategy.
However, an investment strategy based solely on the debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other criteria, as discussed below.
Here are the other parameters:
Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.
Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.
Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.
Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.
Zacks Rank #1 (Strong Buy) or #2 (Buy): No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 or 2 have a proven history of success.
VGMScore of A or B: Our research shows that stocks with a VGM Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 20 stocks that made it through the screen.
Barnes Group, Inc. (B - Free Report) : It is a global industrial and aerospace manufacturer and service provider. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 11.60% in the trailing four quarters.
TriCo Bancshares (TCBK - Free Report) : This is a bank holding company for Tri Counties Bank. It carries a Zacks Rank #2 and came up with an average positive earnings surprise of 9.59% in the trailing four quarters.
EMCOR Group, Inc. (EME - Free Report) : This corporation is engaged in design, integration, installation, start-up, testing, operation and maintenance of complex mechanical and electrical systems. It delivered an average positive earnings surprise of 11.69% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Teradyne, Inc. (TER - Free Report) : It is a manufacturer of automatic test equipment and related software for the electronics and communications industries. The company carries a Zacks Rank #2 and came up with an average positive earnings surprise of 23.76% in the trailing four quarters.
Vodafone Group PLC (VOD - Free Report) : It is the world's largest international mobile communications firm. It primarily operates digital and analog cellular telephone networks of Vodafone. It carries a Zacks Rank #2 and has a long-term earnings growth rate of 6%.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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